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401(k) Plans In The Cross-Hairs

To learn more aobut 401(k) fee litigation, visit our 401(k) Fee Litigation Update Center.

A recent spate of litigation involving 401(k) plan fees has drawn the attention of employers, the media, and Congress. At issue in these cases is hundreds of millions of dollars in potential liability, and also the very backbone of the retirement plan industry. Employers can expect more scrutiny of their plans from employees and, in some unfortunate circumstances, from plaintiffs’ attorneys.

Class action attorneys have identified their next target, and it isn’t cigarette manufacturers, pharmaceuticals, or falling stock prices. Instead, they have in their sights something that is much more pervasive in the business community, and potentially more explosive: the 401(k) industry and employers who participate in it. A series of class action lawsuits filed in late 2006 and early 2007 challenges the way that employers pay for the 401(k) plans that they sponsor. At last count at least seventeen cases were pending in federal courts from Maryland to California, each arguing that investment-related fees paid by plans to their service providers were so excessive as to violate the Employee Retirement Income Security Act of 1974 (“ERISA”).

Coming on the heels of the stock-drop cases that continue to plague employers that offer company stock funds in their plans, this new rash of litigation has the potential to affect many more plans and plan sponsors. These lawsuits attack the basic fee structure used by most 401(k) plans. They have received significant media attention, leading to increased scrutiny from legislators and plan participants. And although the courts have not yet considered the merits of the claims, they are already altering the way that plans are administered.

The Substance of the Claims
The current challenges come primarily from participants in employer-sponsored 401(k) plans. Long predicted by benefits prognosticators, this new wave of litigation is largely driven by three factors: demographics; the growing prevalence of 401(k)-type arrangements as the primary source of retirement savings; and the stock market. As the vast majority of American workers face the prospect of retirement without the security of a traditional defined benefit retirement plan, the investment options made available to participants in 401(k) arrangements and the net investment return on those options will increasingly come under scrutiny. Ultimately, these lawsuits can be traced to the convergence of these three factors.

According to the complaints, administrative fees paid by the plans – and indirectly paid by plan participants – were excessive, improperly diluting the returns on participants’ 401(k) investments. The lawsuits seek to recover what could amount to many millions of dollars from plan sponsors and executives who allowed the plans to pay the allegedly excessive fees, and in some cases from the plan service providers who received those fees. Although the employers and plans that have been sued so far are very large, including Kraft, International Paper, Caterpillar, and Boeing, the legal theories advanced by the plaintiffs would apply to almost every 401(k) plan and plan sponsor. With over $2.9 trillion in the 401(k) industry at stake and baby boomers on the cusp of retirement, it’s clear that these issues are not going away soon.

Revenue Sharing Under Fire
The common theme among all of the cases that have been filed to date is an attack on a practice the plaintiffs characterize as “revenue sharing.” That term can have different interpretations depending upon the kind of investments offered under a plan (e.g., annuity contracts, collective trusts, and mutual funds). In the context of mutual funds – perhaps the most common 401(k) investment vehicle – revenue sharing generally refers to a practice in which mutual fund companies carve off a portion of the management fees they receive from investors and then “share” that revenue with other service providers with whom the fund companies sub-contract. Revenue sharing is a practice that is common throughout the 401(k) industry.

One of the allegations in the class complaints is that plan fiduciaries did not understand the complicated fee structures that are common in the 401(k) industry. For a more detailed explanation of those structures, please refer to the discussion found at Understanding 401(k)Fees.

The complaints characterize revenue sharing payments in two ways. First, the plaintiffs claim that these payments amount to “hidden” fees, largely because they are difficult to understand and rarely disclosed to participants. Second, the plaintiffs contend that revenue sharing payments are actually assets of the plans which are improperly used to benefit parties other than plan participants, in violation of ERISA’s “exclusive benefit” and “prohibited transaction” rules. The complaints characterize these payments as “the big secret of the retirement industry.”

The plaintiffs allege that the defendants in these cases breached their fiduciary duties under ERISA by failing to investigate whether the plan’s service providers received revenue sharing payments. They contend that plan expenses could have been reduced – and participants’ investment earnings could have been increased – if the defendants had uncovered these arrangements and used that information to negotiate for lower fees. They also suggest that defendants violated ERISA by failing to disclose the existence of revenue sharing payments to participants.

Other Claims
lthough the attack on revenue sharing is at the core of these suits, the plaintiffs challenge a number of other practices as well. A few of the complaints argue that some direct (or “hard dollar”) payments from the plans to their service providers were not adequately disclosed to participants. For example, they say that this happens when plans participate in master trust arrangements (which are trusts that pool the assets of multiple plans), and payments are made to service providers from the master trust. The lawsuits suggest that fees paid directly from the master trust – rather than from a component plan – were not disclosed to plan participants, making it appear that plan expenses were very low or even nonexistent.

Some of the plans offered participants the ability to invest in mutual funds that charge a fee for active management, but that allegedly behave like passively managed index funds. The complaints assert that the returns participants earned on those funds were virtually identical to the returns they could have obtained from an index fund which has a much lower management fee. They argue that the management fees imposed by these alleged “shadow index funds” were therefore excessive, and that the plans’ fiduciaries should not have accepted them.

In a few of the cases the plaintiffs take aim at practices associated with employer stock funds. These funds allow (and in some cases require) plan participants to invest in the stock of the plan sponsor. The participants contend that the employer stock funds charged improper management and administration fees, when there really was no “management” of the fund at all. They also argue that fiduciaries allowed excessive cash to be held in unitized employer stock funds, thus diluting returns.

End Run on Section 404(c)
Also common to all of the lawsuits is the plan participants’ assertion that they were not fully informed about the expenses associated with their accounts. This, they say, vitiates the protection from liability that plan fiduciaries might otherwise have had under Section 404(c) of ERISA. The implication is that participants whose 401(k) accounts suffered investment losses could seek to recover those losses from the fiduciaries, in addition to the allegedly excessive fees.

Most plans that allow participants to choose how to invest their money do so in reliance on Section 404(c). That statutory provision protects plan sponsors and fiduciaries from liability for any losses participants may incur when making their own investment choices. However, this protection applies only if participants are given sufficient information with which to make investment decisions. According to the participants, by failing to provide adequate information about plan expenses, the fiduciaries did not comply with Section 404(c), and thus they remain responsible for any investment losses the participants may have suffered.

Assessing the Risk
The defendants in the currently pending suits are mounting a vigorous defense, filing a flurry of preliminary motions. Based upon the arguments they have raised to date and recent decisions by courts in the Fourth (LaRue v. DeWolff, Boberg & Assocs.) and Fifth (Langbecker v. EDS Corp.) United States Circuit Courts of Appeal, it appears that the plaintiffs will have an uphill battle. Nevertheless, these cases will be heavily fact-dependent, and are unlikely to be resolved in the early stages of litigation.

Of equal concern may be the possible legislative and regulatory responses to these lawsuits. Already the U.S. House Committee on Education and Labor has held hearings to address 401(k) fees. More hearings are set for later in the year. The Department of Labor also is considering several initiatives to regulate the relationships between plans and their service providers, and to increase the transparency of retirement plan fees. Thus, the changes that emanate from Washington could have a more significant impact on employer-sponsored 401(k) plans than the threat of litigation.

What’s Next?
It is likely that more lawsuits will be filed in the coming months. Although the St. Louis-based Schlicter, Bogard & Denton law firm is primarily responsible for the current wave of litigation, there are indications that other plaintiffs’ firms are poised to join the fray. Internet reports indicate that a large firm with a well-established ERISA practice is “investigating” the fee practices of insurance companies that provide retirement plan services. Moreover, the Schlicter firm has placed newspaper advertisements to solicit potential plaintiffs for lawsuits that target at least 15 additional plans.

More recently, plaintiffs have added plan service providers to the list of those they sue. In each of the last three cases filed by the Schlicter firm, Fidelity Management Trust Co. and Fidelity Management Research Co. have been named directly as defendants. In those cases, Fidelity’s involvement with the investment funds offered under the plans was allegedly so pervasive as to make Fidelity an ERISA fiduciary with respect to the plans. In addition, plan sponsors themselves have sued insurance company providers directly – Nationwide, The Hartford, and Principal – in what purport to be national class actions on behalf of all plans and plan sponsors that have engaged those entities.

Cases are now pending in federal district courts in the Second, Sixth, Seventh, Eighth, and Ninth Circuits. As these matters proceed, it is likely that the courts will render substantive interpretations of ERISA that are not always consistent. Unless Congress intervenes, it will be up to the Supreme Court to explain the extent of the rights and obligations that employers – and employees – have with respect to 401(k) plans. Thus, for some time to come these lawsuits will shape the legal landscape in which retirement plans are administered.